Credit Scores: How Do They Work?

FICO credit scores determine whether you’ll qualify for a loan or credit card, and if so, what your interest rate will be. A low score can cost you thousands of dollars over the life of a mortgage To help you learn more about this vital piece of information, I cover what goes into your scores and what you can do to fix them.

How Credit Scores Are Determined

As I mentioned on Monday, there are now two breeds of credit scores: the VantageScore and the more familiar FICO score. The FICO score is used by most lenders and creditors. Although the exact formula is proprietary, FICO says that it currently ranks the following elements of your credit history:

35% payment history

30% outstanding balances

10% types of credit you hold (loans, credit cards, etc.)

15% credit history length

10% recent history

The resulting number is a three digit score between 300 and 850. The average credit score in the U.S. is 723, which is considered good.

The Credit Score Scale

If you’re even moderately aware of the mortgage industry, then you know that scores are grouped into three tiers by mortgage lenders:

Prime

Alt-A

Subprime

Subprime borrowers were previously considered to have scores below 620. Alt-A borrowers had scores between 620 and 720, but also often had high debt-to-income or low loan-to-value ratios, were self-employed, or had other factors that made them higher risk. Prime borrowers had scores above 720, solid employment, low debt, and a good down payment, all of which made them lower-risk.

Rather than tiers, FICO divides the scores into the following range. As you can see, the range helps determine your interest rate. The difference between the first two tiers is $42 a month on a $300,000 loan. It’s $97 a month between the first and third tiers.

Each of the three bureaus generates its own FICO scores. Lenders generally pull all three and then use the middle score. If you have a co-borrower, they will use the middle score of the lower-scoring borrower. For example, if one of you had 720, 730, and 740 and the other had 660, 670, and 680, your rate would be determined based on a score of 670.

How to Get Your Credit Score

Unfortunately, your credit score is not available for free at AnnualCreditReport.com. You can either buy them from the credit bureaus, or buy them with your reports at MyFico.com. If you’re currently applying for a loan, you can ask the lender to show them to you. If you have a Washington Mutual Credit Card, you can view one of your scores for free anytime.

As far as I’m concerned, credit reports and scores should be available to consumers for free at any time. The credit bureaus make most of their money selling the information to banks. Their information is our personal information, which is used to make decisions about our financial lives. We shouldn’t have to pay to see something based on our own data.

How to Fix Your Credit Score

If your credit score is low, you can take a few steps to boost it, but you may also inadvertently harm your score. You should never pay someone to repair your credit score. Anything they could do, you can do for free yourself.

Review Your Credit Report.

The most important thing you can do is review your credit reports and correct errors to the bureaus. Incorrect negative information can have a major impact on your score, and fixing it is usually simple. Don’t dispute negative items that are accurate, though. Even if the bureaus temporarily remove them, they will return because the information is correct.

Don’t Close Old Credit Accounts.

There’s a lot of conflicting information about how cancelling credit cards affects your score. The current advice is to leave them open. This is especially true of your oldest card. If you’ve had one card for fifteen years and the rest for five, cancelling the oldest card will shorten your credit history, which negatively impacts your score. There are exceptions, though.

Become the Co-Owner of a Card with Good History.

A year ago, you could be an authorized user and have the benefit of the owner’s account history applied to your score. Due to fraud, FICO stopped doing that. You do still get a score boost if you’re the co-owner of the card (and therefore legally responsible for it.) My husband had an old card with a fee and a low limit. When we got married, we made him the co-owner of two of my oldest cards and then cancelled his younger, high-fee-low-limit cards. Remember, though, that you’re on the hook for any debts incurred on the card if you’re a co-owner, so this is really only a good idea for spouses.

Don’t Open Several Accounts Before Applying for a Loan.

New credit accounts detract from your score. The general rule of thumb is to avoid acquiring new credit for one year before applying for a home or car loan.

Don’t Pay Off Really Old Debts.

Collections and old debts fall off your report after seven to ten years. Even if they’re still on your report, they have less impact as they age. If you pay them off, you may inadvertently refresh them and lower your score more.

Even though your score affects your borrowing ability, there’s no reason to stress about it until it’s time to apply for a new loan, or if your credit card interest rate shoots up. Then you can take steps to improve it to lower your costs.